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Mistaken assumptions
As with anything else, analyses of the performance of asset classes are reliant on the quality of the data used to make the assessments. In that regard, new research from Daniel Barth, et al., is particularly interesting. It doesn’t address the performance of an asset class but of “hedge funds,” that varied collection of investment strategies that gets lumped together.
The conclusion is that many analyses of hedge fund performance are misleading because they are based upon data from commercial database vendors. Those databases are voluntary, and the authors find that hedge funds who don’t participate in those databases “have less fragile capital and higher alphas” than those that do.
Larry Swedroe has published an excellent summary of this important research.
Data governance
The lede for the latest paper (“Governing Your Way to Better Long-Term Returns”) by Dane Rook and Ashby Monk:
Data governance isn’t sexy, but it can lead to better investment decision-making, which in turn can lead to better investment returns . . . and better returns are always sexy.
The paper draws a line between data management (“how efficiently data is handled”) and data governance (which is “concerned with how the quality of data affects the quality of investment decisions”), and the authors stress that data governance “must align with the technology, culture, organizational structure, leadership and other resources an investor uses when it makes investment decisions.”
While written for asset owners, the ideas put forth by Rook and Monk apply equally to other kinds of investment organizations.
Getting unstuck
Unusual events offer researchers the opportunities to analyze changes that are otherwise hard to see. The pandemic has spawned quite a bit of academic research along those lines (and there will no doubt be much more to come across a wide range of fields).
In a paper, “Do Firms Get ‘Stuck’ Issuing Quarterly Earnings Guidance?” Andy Call, et al. took the opportunity to study changes in guidance practices by U.S. companies in response to the onset of the pandemic. The chart above shows the number of firms over time that stopped guidance and did not restart it. In response to the pandemic, 180 firms discontinued guidance, but 110 subsequently restarted it. The seventy who did not represent the two-quarter spike you see and are the subject of the analysis.
The provision of guidance, the earnings management practices of companies, and the resultant guessing games about their motivations by analysts make for a fascinating aspect of equity investment activity. Many decry the game as it is played, but most companies still engage in the practice of giving guidance.
Two sections from the authors summarize the results of their analysis:
We find that the post-stoppage abnormal returns (subsequent 6-month and 12-month returns) of firms that stopped guidance during the pandemic are significantly positive, whereas the subsequent returns of firms that stopped guidance between 2010 and 2019 are consistently negative.
We interpret these results as evidence that many firms viewed the COVID-19 pandemic as an opportunity to exit the guidance game when the likelihood of a market penalty for stopping was low, and when investors would be less likely to interpret the absence of guidance as a negative signal about future performance.
Speaking of company guidance, another paper, by Lauren Cohen and Quoc Nguyen, finds that firms “strategically move their targets in reporting performance to investors,” but that “investors fail to realize or take into account the valuable information in these simple changes in targets.” At a time when everyone is getting excited about the possibilities of AI:
While technology could also aid in the collection and processing of this same information, we show that far from needing complicated state-of-the-art solutions, simply collecting performance targets from year to year [provides] powerful information that is seemingly being ignored by the capital markets.
The big dog
Fidelity’s brokerage division has said it will add a $100 fee for purchase of ETFs from sponsors that haven’t agreed to share revenues with it. That has spawned a number of articles in the press and reactions from the financial blogosphere and Twitterverse. A Citywire RIA article covers the basics, a LinkedIn posting from Meb Faber (CEO of one of the affected ETF sponsors) argues against the new policy, and a piece from Dave Nadig provides important industry background and perspective, including:
I’m not defending the move by Fidelity here — at best it’s ham-handed and wildly too much, too fast, without context. At worst it’s just plain stupid and won’t make them any more money. But I also do not believe that the last 20bps or so for distribution in financial services is ever going to really go to zero.
Free is always a fake price. Free means someone else is paying, or you’re paying and just haven’t figured out how. “Free Shipping” is never free.
Limited partner management
“Mastering LP Management,” by John-Austin Saviano of High Country Advisors, was published in March 2023, but hasn’t been highlighted in a Fortnightly before. It offers asset managers worthwhile tips on interacting with their clients. After all:
The stakes are huge. Happy LPs stay with their managers longer and are advocates for managers in the marketplace. Conversely, unhappy LPs will seek other homes for their capital and can send negative signals to their peers.
Other reads
“Valuation Multiples,” Michael Mauboussin and Dan Callahan, Morgan Stanley.
This report discusses four topics. The first is what multiples miss and why they are becoming less informative than they were in the past. Second is an examination of why the two most popular multiples that equity analysts use, P/E and EV/EBITDA, can provide different signals about a stock’s relative attractiveness. Third is a look at the alternative measures of earnings and EBITDA that companies report to see if they add insight. Finally, we focus on EV/EBITDA multiples and link them back to fundamental drivers of value.
“Building Blocks and Costs of an Internal Investment Office,” Strategic Investment Group. Based upon a limited sample, some estimates of costs for different sizes of asset owners, plus comparisons of inhouse, OCIO, and hybrid approaches (from an OCIO manager).
“Money for Nothing? Hedge Funds Haven’t Budged on Hurdle Rates (Yet),” Chris Stevens, bfinance.
What used to be an essentially academic distinction in net returns for the two types of fee structure during the ‘ZIRP’ era has now become a very meaningful difference.
“Charting a New Course,” Scott Treloar, Noviscient. On the importance of both long-term and short-term thinking in investment organizations.
“Is the Boom-and-Bust Business Cycle Dead?” Talmon Smith, New York Times. A perceptive assessment of a new order — or wishful thinking?
“But one point to keep in mind,” [Rick] Rieder continued, “is that satellites don’t land and maybe that is a better analogy for a modern advanced economy” like the United States. In other words, dips in momentum will now happen within a steadier orbit.
“International Intangible Value,” Kai Wu, Sparkline. An extension of Sparkline’s previous research on intangibles — offering a third way between international stocks being viewed either as “an amazing contrarian buying opportunity” or “value traps”?
“A framework for allocating to cash: risk, horizon, and funding level,” Vanguard.
There is a clear need for cash in financial planning, but from a portfolio construction perspective, the need for cash depends on the investor’s circumstances and mindset.
“Most Financial Phenomena are Older than they Look,” Byrne Hobart, The Diff. A book from 1900 shows that times may change but people’s inclinations don’t; “Conflicts, revenge trades, YOLOing into options — it’s all there.”
“How to Solve the ‘Willie Nelson’ Problem,” Gapingvoid.
How does a person or an organization keep its creative vitality once they have already become successful, already become comfortable?
The right stuff
“The art of being wise is the art of knowing what to overlook.” — William James.
Flashback: Linear thinking (in a nonlinear world)
A 2017 article in Harvard Business Review by Bart de Langhe, et al. provided a number of examples of how “the human mind struggles to understand nonlinear relationships” in a business context.
Written for corporate executives, it provides a number of examples of ways in which assumptions of linearity lead to poor decision making. Those examples, accompanied by simple diagrams, are instructive for investment analysts, who can suffer from the same misconceptions.
As noted in the piece, it is not just the basics of costs, volumes, and price for which the linear/nonlinear dynamics come into play, but things like consumer attitudes. Environmental concerns versus purchase behavior is offered as a good example.
Other kinds of nonlinearity come into play in the investment realm. For example, mortgage repayments and investment fund flows often follow nonlinear patterns. And things that resist quantification can suffer from straight-line thinking too — to wit, the social nature of investment ideas means that they accelerate and decelerate in popularity in nonlinear ways.
Postings
The archives include all of the previous postings. You can also sort them by category or search by keyword.
For instance, two years ago the essay “Decisions with Other People’s Money” examined the principal-agent problem, including the effects of social relationships, incentive structures, and differential risk preferences between principals and agents.
Thank you for reading. Many happy total returns.
Published: April 29, 2024
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